How Financials Can Outperform

At first blush, the upcoming earnings season should be great for large cap US Financials. A few data points:

  • FactSet shows the group set to report 19.8% earnings growth versus last year.
  • Analysts have been tweaking their numbers higher in the last few days as well, unlike most other S&P sectors.
  • Financials should see some of the best operating margin expansion of any group, with a 2.6 percentage point pickup from 14.6% in Q1 last year to 17.2% now. That’s better than Tech (only 1.3 points of margin growth) or the S&P as a whole (0.9 points)
  • As long as management guidance doesn’t disappoint, Q2 should be very strong as well. Analysts have 19.6% earnings growth penciled into their models there.

Here’s the funny thing, though: those same Wall Street analysts with the big earnings expectations have some of the least bullish price targets of any sector. The numbers:

  • As of last Friday, the analysts that cover Financials had an average price target for their names only 14.0% higher than where the stocks currently trade.
  • There are only two other groups with less bullish analysts: Real Estate (mean price target 10.3% above current prices) and Utilities (4.8% above). Given a widely expected move to higher interest rates, that caution makes sense. But that same macro driver should be getting Financials analysts bulled up, and they clearly aren’t.
  • For comparison, Wall Street analysts have price targets 16.2% above current prices for the typical S&P 500 stock. Health Care and Technology analysts are the most excited about their groups, expecting 18-19% price appreciation.

The missing link between earnings and prices is, of course, valuation. Simply put, Wall Street is bullish on earnings and negative on P/E multiples for the Financial sector. When you look at the numbers, the market clearly shares that point of view.

We pulled the current P/E multiples for the 5 largest market caps in Financials (ex Berkshire, which is its own animal) and compared them to where these stocks traded exactly a year ago. Both assessments use one-year forward earnings for their respective years. Here’s the result:

JP Morgan

  • Now: 12.8x
  • A year ago: 12.2x

Bank of America

  • Now: 12.3x
  • A year ago: 12.4x

Wells Fargo

  • Now: 11.8x
  • A year ago: 13.7x

Citigroup

  • Now: 11.2x
  • A year ago: 11.0x

Goldman Sachs

  • Now: 11.9x
  • A year ago: 11.4x

Bottom line: the average multiple for these names is unchanged over the last year (12.1x then, 12.0x now). A few are slightly higher, a few lower. None are even at 13x.

Our take: the investment case on Financials has nothing to do with near term earnings, but instead with potential P/E multiple expansion. Let’s be honest – these are atrocious valuations. It’s not like the returns on equity are bad for these companies. Even before getting into commonly accepted tweaks like “Tangible book value”, their ROEs average 9.5%, well over a cost of capital of 7-8%.

To like the group from here (and we do), one has to argue for some secular positives:

  • A less restrictive Federal Reserve that will allow for greater return of cash to shareholders, either in the form of dividends or buybacks.
  • Significant earnings power during the next recession – enough to continue paying dividends at the very least (which will also require Fed approval).
  • The upside potential of Fintech offerings within traditional banking. These can lower costs to both the companies and consumers, as a recent Fed paper about online mortgage companies showed.
  • Continued diligent cost controls, even when times are good (as they are now).

We’ve seen this movie before; many cyclical stocks (think CAT and DE) entered the 1990s with equally sorry valuations and similarly skeptical investor bases. It took them essentially a generation to re-earn the market’s trust and achieve higher multiples. Neither had the threat of regulation as a headwind, to be sure. But the point stands: multiples do change, given enough time and positive performance.

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